Employee and independent contractor classification: Still the top legal issue in franchising

Over the last few years, there have been developments, both legislative and judicial, regarding the classification of “employees” and “independent contractors.” These developments pose a serious threat to the franchise model.

The franchise relationship is built on the premise that the franchisor has developed a system which it licenses to independent contractors who own and operate their individual businesses in accordance with the requirements of that system. The view that the franchisor is somehow an employer of the franchisee, or even a joint employer of those who work for the franchisee, is inconsistent with the fundamental concept of franchising.  Recent developments in the law of employee/independent contractor classification raise concerns for the future of franchising.

In 2018, the Supreme Court of California, in a case called Dynamex Operations West v. Superior Court, 4 Cal. 5th 903 (2018), addressed the standard to be applied in determining who can be classified as an “employee” versus an “independent contractor.” Rather than following prior longstanding precedent, the Supreme Court adopted what is called the “ABC” test – a test applied in a few other jurisdictions. Under that test, a “worker” is only properly classified as an “independent contractor” if the “hiring entity” establishes these three prongs: 

A. that the worker is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract and in fact

B. that the worker performs work that is outside the usual course of the business of the hiring entity and

C. that the worker is customarily engaged in an independently established trade, occupation or business of the same nature as the work performed.

Prong (A) may present a problem for a franchisor which must impose certain controls and direction on the franchisee to protect its system and trademark and to achieve the consistency between franchise outlets that is the hallmark of franchising.  Prong (B) – establishing that the “worker” performs work outside the usual course of business of the franchisor – may pose an even greater problem, because most franchisors may be considered to be in the same business as that of their franchisee.  This is particularly a concern if the franchisor operates company-owned units.

The ABC test, at the urging and intensive lobbying of union representatives, was essentially codified by the California legislature in what is called Assembly Bill 5 (AB5), which became effective in that state on January 1, 2020.   Despite lobbying by franchisors, the California legislature did not incorporate an express exemption for franchising in the legislation.  

Other states may also propose legislation which would follow the approach of AB5.With the recent change in national administration, it is unclear whether the federal government may do the same. Even efforts to limit the application of the Dynamex ruling to prospective relationships have failed: the Supreme Court of California at the beginning of this year held that that decision applies retroactively.(See Vazquez v. Jan-Pro Franchising International, Inc., No. S258191, slip op. (Cal. Sup. Ct. Jan. 14, 2021).)

Legal challenges to the applicability of AB5 to franchising continue.   In November 2020, our firm filed an action in federal court in San Diego on behalf of the International Franchise Association, joined by a group of franchisee associations, seeking a determination that AB5 cannot apply to franchising because it is pre-empted by the Federal Trade Commission (FTC) Franchise Rule and the federal Lanham Act.  (International Franchise Association, et al. v. State of California, et al., Case No.  20CV2243 (S.D. Cal., filed November 17, 2020).) That case is pending and no decision has yet been issued.   

One of the theories on which that complaint is based has already been recognized by at least one court. In Dhananjay Patel v. 7-Eleven, Inc., 2020 WL 5440623 (D. Mass. 2020), the United States District Court for the District of Massachusetts held, in the context of the ABC test which is in effect in that state, that there is an “inherent conflict” between the definition of the franchise relationship under the FTC Franchise Rule and the ABC test.  (Our firm represented 7-Eleven in the case.)The court granted summary judgment to 7-Eleven, concluding that the franchise-specific regulatory regime of the FTC Rule governs over the Massachusetts ABC test.

This area of the law continues to evolve, and it remains to be seen whether in 2021 the courts and legislatures will protect the basic premise on which the franchise relationship rests – namely, that franchisees are independent contractors and not employees.

Find out more about this evolving trend by contacting the author or your usual DLA Piper relationship attorney.